The Rise of Vertical Integration, 1990-2001

It is useful to describe how the different kinds of banks found a niche in the emerging mortgage securitization industry being created by the GSEs. Making and selling securities was one of the basic businesses of the investment banks.

The mortgage banking business where banks specialized in originating mort­gages was in its infancy when the GSEs replaced the savings and loans with the mortgage securitization model. Banks who were trying to compete with the sav­ings and loans for mortgages had a difficult time doing so. But when the GSEs began to aggressively purchase mortgages in order to create their new securities, these banks seized the opportunity to become suppliers to the GSEs. Mortgage banks would raise capital to broker loans by selling through real estate agents or would buy loans from others who originated them. They would then turn around and get their capital back by selling these loans to the GSEs. Eventually, the largest of these mortgage banks spread their activities to other parts of the securitization industry.

One industry that came to be important during the 1990s for participating in origination, securitization, and investment were the commercial banks. The commercial banks were faring no better than the savings and loans banks during the 1970s and 1980s. Davis and Mizruchi (1999: 219-220) show that commercial banks lost their core lending markets to other financial entities during this pe­riod. Corporations stopped going to banks for loans and instead went directly to the financial markets to raise money. Consumers stopped putting money in savings accounts in banks and began to invest in money market funds and a wide variety of stock and bond mutual funds.

Commercial banks began to search out other market opportunities. They be­gan to look in two directions. First, they wanted to diversify by entering more lucrative businesses such as investment banking and the buying and selling of stocks, bonds, and insurance. From the mid-1980s, the commercial banks pushed to undermine and circumvent the legal strictures that kept them out of these lucrative businesses, namely the Glass-Steagall Act (Barth et al., 2000). Their central argument was that such regulations were obsolete because market changes had blurred the lines of financial services.

The Federal Reserve, the regulatory authority for commercial banks, support­ed them in this effort (Hendrickson, 2001). The Federal Reserve adopted very lax standards in enforcing the legal barrier between investment and commercial banking. They took the position that as long as less than 50 percent of the business of commercial banks was involved in investment banking activity, there was no violation. Not surprisingly, commercial banks entered into various kinds of invest­ment banking during the 1990s. In 1998, Citibank audaciously purchased Traveler's Insurance (along with its brokerage firm and investment bank), making the bet that the last regulatory barrier, the Glass-Steagall Act, would be repealed. After­ward, the Clinton administration and Republicans in Congress did just that with the passage of the Gramm-Leach-Bliley Act of 1999. With the repeal of Glass-Stea­gall, any financial firm could freely enter any financial industry.

The second important change in the commercial banking industry during the 1990s and early 2000s involved a shift in their basic business model. During the 1970s and 1980s, banks tried to build relationships with their customers in the hopes of selling more banking services to individuals and corporations. But by the early 1990s, commercial banks, which had seen their customers migrate to other finan­cial firms, changed their view of customers. Instead of viewing their main business as being about building relationships with customers through the selling of loans, they began to see their industry as about charging fees for services, much as invest­ment banks had long done.

The most important fee-generating business quickly became the origination and securitization of mortgages. This is because customers for mortgages were charged a large number of fees to engage in a transaction. The sale of those mort­gages to special purpose vehicles and the production of MBSs also generated fees. Finally, the selling of those MBSs generated fees as well. It is not too strong to say that the creation of the mortgage securitization market by the GSEs saved the commercial banking industry. DeYoung and Rice (2004) document these changes across the population of commercial banks. They show that income from fee-related activities increased from 24 percent in 1980 to 34.8 percent in 1990, 35.9 percent in 1995, and 47.1 percent in 2003.

The joint effect of these two institutional shifts—the deregulation of financial service boundaries and resulting conglomeration on one hand, and the reori­entation from loans to fee revenue on the other—was that different types of fi­nancial services firms all coalesced around mortgage finance as a core business. Within the mortgage finance business, banks began to integrate either backward into mortgage origination or forward into mortgage securitization. The main reason that banks began to integrate was that they realized that there were op­portunities to earn profits at all points in the chain from origination to invest­ing. But some of the integration was defensive as well. As originators decided to build their own securitization platforms, they began to keep more and more of the mortgages they originated in-house. Those who were involved only in the securitization business found themselves in increasing competition for existing mortgages. This pushed those who wanted to do securitization to own a mort­gage originator or have an arrangement with an existing company.

We see this integration occur among all kinds of banks. By 1999, Bank of America, Citibank, Wells Fargo, and JPMorgan Chase (all commercial banks) had shifted their businesses substantially from a customer-based model where individual households and firms were the main target for their financial prod­ucts to a fee-based model centered on originating mortgages, creating securities, and selling and holding mortgage securities.

Countrywide Financial started out as a mortgage broker, while Washington Mutual Bank was a savings and loan bank. Countrywide Financial entered origi­nation, securitization, and trading. Washington Mutual quickly entered securiti­zation beyond its traditional business of making mortgage loans. On the invest­ment banking side, Bear Stearns was a pioneer in integration when they entered the mortgage origination business by setting up lender and servicer EMC in 1993. Lehman Brothers, another investment bank, was also an early mover into the mortgage banking business, acquiring originators in 1995, 1999, and 2003 (Currie, 2007). Industrial product lenders GMAC and GE Capital moved ag­gressively into the market for originating mortgages and eventually into issuing and underwriting MBSs (Inside Mortgage Finance, 2009).

By 2000, a new business model had emerged in the mortgage market. The market for mortgage securitization was still centered on the GSEs for the conven­tional market. But banks of all kinds had over the course of the decade moved to increase the scope of their businesses by entering into all of the transactions in the market. The product mix of the financial conglomerates that were centered on mortgage finance meant that the largest banks were all becoming the same bank.

The final part of the story of the 1990s concerns the beginnings of the market for nonconventional mortgages. In the world of 1985, the number of products avail­able to consumers to finance mortgages was quite limited. The main product was the conventional mortgage, which required households to have a 20 percent down payment, a mortgage amount limited to 30 percent of their monthly salaries, and a credit score above 650. In return, households got a fixed interest rate payment, usually for thirty years.

Households who had poor credit or could not come up with the down pay­ment were simply unable to buy a house. It was also nearly impossible to access equity in a home to use for household expenses. Beginning in the early 1990s, small consumer lenders such as Associates First Capital, Beneficial Finance, and Household Finance started to experiment with lending money to households with impaired credit, those who could not put down a down payment, or those who wanted a home equity loan. The subprime business grew from $37 billion in 1990 to $62 billion in 1995 to $130 billion in 1999. These mortgages came with both higher fees and higher interest rates. By the mid-1990s, this business began to attract the attention of the larger banks. In 1999, Citibank, Washington Mu­tual, Bank of America, and Countrywide Financial joined Household Finance (which was bought out the next year by HSBC, a large British bank) as a top five producer. The business had grown to $130 billion.

Other market segments developed during the 1990s in much the same way. The home equity loan business where households could borrow money against the equity in their homes was a $20 billion business in 1990, $44 billion in 1995, and $75 billion in 1999. Early on, it too was dominated by many of the same lend­ers in the subprime market, such as Beneficial Finance and Household Finance. But by 1999, Citibank, Lehman Brothers, Countrywide Financial, and Bank of America were among the top five lenders in making home equity loans.

Many households were living in housing markets where price appreciation during the 1990s had sent housing costs through the roof. This meant that while they might have had good credit scores and were able to afford the monthly payment, coming up with the down payment was very difficult. The GSEs decide whether or not to purchase a loan to package into a security based how much they determine is the maximum a person can borrow. This limit became a barri­er to households in high-priced parts of the country on both the East and West Coasts. So, banks began to offer a new product, what became known as a jumbo loan, where the person has good credit but needs to borrow an amount above the conventional conforming loan limits. Traditionally, the interest rates on jumbo mortgages have been higher than for conforming mortgages.

That market for jumbo loans grew dramatically from $88 billion in 1990 to $135 billion in 1995 and finally $315 billion in 1999. It too became dominated by the largest banks, with Washington Mutual, Countrywide Financial, Bank of America, Lehman Brothers, and Wells Fargo being the top five producers in 1999. Finally, adjustable-rate mortgages, which had existed at an earlier date, grew in importance as well. In 1990, $128 billion in adjustable-rate mortgages were originated. In 1995, this rose to $232 billion, and in 1999, it was $318 billion. By 1999, Washington Mutual, Lehman Brothers, Bank of America, Countrywide Financial, and Bear Stearns were the top five originators.

By 2000, the broad outlines of the mortgage securitization industry could be discerned. The largest financial institutions in the country were originating and securitizing a large number of loan products. They were buying and sell­ing the securities based on those products. Most of them could be character­ized as integrated producers. The proliferation of mortgage products produced new opportunities for both households and financial institutions. The business model of the modern financial institution was to produce in all segments of these markets and to invest in the securities produced by those segments. Not only had these markets grown in size, but the largest banks held large market shares in many of these markets. The mortgage industry was a $1.0-1.5 trillion industry by the end of the 1990s. It is this structure that was in place when the 2000s opened with a serious recession and the Federal Reserve dropped interest rates. This created a once-in-a-lifetime opportunity to expand their businesses, and in three years, the industry grew from financing $1.0 trillion in 2001 to $3.8 trillion in 2003.